Blog 83: The 4% Rule

Blog 83: The 4% Rule

This week we are taking a closer look at the fabled '4% Rule' relating to drawing-down on investment or retirement pots. This particular 'rule' gets plenty of airtime in the US, UK and many other countries but from my own experience very few people here in Ireland seem to have heard of (even many advisors!). Let's try fix that! We are not going to challenge this 4% Rule today, merely we'll determine what it is, how it is relevant and how to go about figuring it out for yourself.

Welcome back to Ireland's only dedicated and straight-talking personal finance blog/podcast. We are on a mission to tell the truth about money and are so thoroughly enjoying the journey! It is always great to hear from listeners so if you have any suggestions or ideas for us to explore please do send me an email here. As an aside, this week I got to meet a bit of a hero of mine. I travelled over to Penzance in Cornwall and spent a good few hours trying to learn as much as I could from the one and only Pete Matthew who has been creating really engaging personal finance information via video, blogs and podcasts for 5 years now. Such a pro, it was great to meet him. Check out the magic here!

What Is The 4% Rule:

Bill Bengen first articulated the 'safe withdrawal rate' from pensions pots in the 1990's. He is thought to be the 'Godfather' of research in figuring out (or at least trying to!) how much you can safely take out of a pension pot or personal investment each year and not run out of money before you die!

This may all seem a little technical and of little consequence however if you are either trying to build a pot of money/pension to sustain you when you transition from full-time employment, or you are retiring now then it becomes totally and utterly relevant. Another way of looking at all of this is that it's essentially like trying to make your large drink of coke at the cinema last you the duration of film, instead of realising 20-minutes in that your drink is all gone but you have still half a bucket of popcorn to get through, except the stakes are a little higher!

Bengen's Safe Withdrawal Rate at the time suggested that you can draw 4% a year from your pot, and increase that amount by the rate of inflation every year, and not run out of money for at least 30 years. This was based however on you leaving your pot invested in a portfolio offering at least 50% exposure to well diversified equities, and the balance invested in intermediate Bonds. For many people the thoughts of having at least half of their savings exposed to the 'risks' of the equity market when they are 60 and 70 and 80 is totally bonkers. However, as we have said time and again if you want to draw an income and you want that income to increase then having it invested in the only asset-class that has delivered long term increasing income (dividends) and capital value (price) is far from bonkers!

It is also worthwhile pointing out that the income of 4% is to rise each year with inflation, something that a lot of annuity products people are offered do not do. And essentially this is what you are trying to do by not buying an annuity, to figure out what level of income you can give yourself, and to be better off than had you handed all your cash over to buy that annuity (plus to give the added advantage of leaving any money remaining to your loved-ones instead of to an insurance company!). Below is a link to Bengen's research paper from way-back which give you all the detail, an interesting read if that is your bag!

Link To Bengen's Paper 'Determining Withdrawal Rates Using Historical Data'

How To Apply It:

If, like I, you are in the stage of life where you are trying to accumulate savings, as well as enjoy your current lifestyle as much as possible then the 4% Rule is a very useful barometer in calculating how much you should save for your retirement. Say for example you are hoping to have a financially comfortable life, and that in order to do so you have worked out (which you should!) that you would need approximately €50,000 gross to do that once you retire. Bear in mind, if you are a couple, that there is every statistical likelihood that at least one of you will live till 90 years of age, that is a 30 year timeframe over which you want to have that income. As a result you definitely will want that income to rise with inflation. Making lots of assumptions here but if you are a couple you might roughly say that the state pension will provide €24,000 of the €50k per year. So by the powers of subtraction we can deduce that you need another €26,000 per year to hit your target of €50,000 gross!

Taking 4% per year (€26,000) out of your pot, and having it rise each year with inflation suggests that you will need to have €650,000 of a pot when you retire in order to sustain you for the 30 years. Bengen's research showed that irrespective of what historical returns he used, irrespective of the market crashes and sequence of colossal bear markets, taking €26,000 per year, increasing it every year in line with inflation means that you never run out of money within 30 years. It is funny because if you were to just divide €650,000 by €26,000 it suggests it will only last for 25 years, and even less (try 20!) if you are increasing that 26,000 in line with inflation each year. That is the power of ensuring it remains invested (see below for more on that!).

As an aside, if you are in your mid 30's right now, you may or may not be a member of a pension scheme with an employer, irrespective of that fact I can't encourage you enough to spend a little time determining what type of lifestyle you would like to have in retirement, and how much you think you would need to have in order to achieve that. Once you have figured that out do the maths! For example, if you are 35, will retire at 65, want to have the €50k as above, so a pot of €650k, and have saved €40,000 so far in a pension pot, you need to be putting approximately €7,000 per year aside from now, and having it grow at 5% Net per year, simple! (Thanks to a kind reader for reminding me to include the fact that you will need to adjust upwards to account for inflation in these calculations obviously!).

If you have recently transitioned from full time employment or are planning on doing so in the near future then you may be looking at a slightly different angle on this. You have your pot established, good or bad as it may be in your eyes. If you apply the 4% Rule it may make you delighted or despair, but as a friend of mine says 'we are where we are'! If 4% of your pot is a figure that will give you the lifestyle you desire then according to Bengen you have every chance of successfully outliving your money. If however 4% falls short of generating the income you seek then you have some options, non of which are ideal:

  1. Take a higher % of your pot each year. This is an interesting one, because there are those that say your spending will reduce dramatically as you get older. When you hit 80 and beyond you may be less able to travel, do things that cost money. For that reason some say the 4% Rule is TOO CONSERVATIVE, and that you should spend more 6,7,8,9,10% per year.....but this is a gamble and one which could lead to a life of little dignity and freedom if money runs out
  2. Don't increase your withdrawal in line with inflation. Again, may not be a terrible outcome and one which could potentially mean you draw a higher % initially and it could last until you shuffle off this mortal coil!
  3. Spend less. The most obvious of the 4 main options, relies on you just taking less than the 4% and potentially do less of the thinks that you enjoy
  4. Keep working until such point as you have enough money/less years to sustain

None of these are ideal, and if you are in that position I do empathise, particularly if  circumstances do stop you from doing things that you would have loved to do. All I can suggest to the rest of us is to make it our mission to ensure we do not suffer the same options when we get to the time when we transition out of full time employment.

What Portfolio:

I mentioned above that Bengen's research suggested the Safe Withdrawal Rate was dependant on the pot being invested and staying invested during both the ups and downs of the equity and bond markets. Traditionally it has been advised (in Ireland at least) that once you hit retirement you need to ensure all your savings are in 'safe assets' beacuse 'well you are old now and can't afford to take any risk'! Total and utter nonsense I'm afraid. The only safe place to be is in assets that have proven to deliver growth. We saw what happens if you get no return (think cash savings), suggesting that the only safe place IS exactly where conventional wisdom suggests it is not! Bengen has the following to say on the subject of how much of your pot should be in a well diversified portfolio of equities and how much should be in Bonds.

"Stock allocations lower than 50 percent are counterproductive, in that they lower the amount of accumulated wealth as well as lowering the minimum portfolio longevity. Somewhere between 50-percent and 75-percent stocks will be a client's "comfort zone."

What Bengen points to here is that unless you invested at least half of your pot in Equities, based on the historical returns of over 100 years, even taking into account all of the terrifyingly scary bear markets and recessions, you would have lost out on years of income. If you have not then I strongly suggest you read this piece we did a few months back which only supports the evidence that Bengen so scientifically arrived upon many years ago.

The 4.5% Rule

This may or may not be the right time to introduce this (i wasnt sure where to put it!) but Bengen has since increased his 4% to 4.5% and suggests that you should be able to safely withdraw 4.5% in your first year, throw away the % and just increase the amount you take in year 2 by whatever last years' rate of inflation was. Indeed he has also called-out the fact that in many scenarios one could safely take 6-7% and not run out within 30 years, however the 4/4.5% allows for a major bear market such as 2008, at the very start of your withdrawal stage and still be safe, however a 7% rate from day 1 leaves one exposed to such bears, and nobody wants to be exposed to a bear of any kind I shouldn't think!

Conclusion:

I honestly don't know if Revenue were reading Bengen's research when they slapped the 'imputed distribution' of 4% (from 61) and 5% (from 71) on holders of ARFs in this country, or if it was purely greed meeting convenience, either way if we are to still go by Bengen's research then it might not be far off the mark as a draw-down strategy, or as a means to calculate how much you should be aiming to squirrel-away for when your time to transition comes!

Thanks for reading, please tell a friend......You're a Legend!

Paddy Delaney

QFA | RPA | APA | Qualified Coach

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